Early today I gave a keynote at the VCJ Venture Alpha conference here in San Francisco. I was asked to speak about the topic of “what is going on in the venture capital world and what is the next big thing after social networking?”

Future of VC Internet –

Tough topic, but what the heck?

Next week I promised to follow up on PE Hub, one of the main journals VCs read about our industry, with a detail description of some specifics that are happening. Watch out for that – I will have a lot more details.

I’ve listed some great VCs in the presentation. I’ve left off many great ones. It isn’t intentional. You can’t cover everybody in a prezzo. Please don’t read anything into that. Some of the big ones I left off was Tim Connors of PivotNorth and Aydin Senkut of Felicis Ventures.

And all feedback welcome! See you in the comments.

This article was originally published on TechCrunch.

Venture Capitalists typically have partners’ meetings on Mondays. Why is that? Who knows. But probably because as a group we travel a lot. So the industry formed around a day of the week when all partners could avoid having company board meetings or traveling.

Yesterday was a Monday. And not a pleasant one.

Rewind. When I first got into the industry it was 2007. Valuations were enormous relative to progress in companies. Web 2.0 was still a term being bandied about. Companies with less than $2 million in revenue were asking for $50-60 million valuations and getting them. My partnership was pretty bearish and scratched our heads a bit at price tags.

It was a great learning time for me. I spent my days meeting companies, figuring out what areas of the market interested me and trying to get a sense for how VCs thought about fair valuations. I thought about things I never had to as an entrepreneur: check size, ownership percentage, deal stage, portfolio construction and risk.

2008

By 2008 I had gotten more serious about championing companies through our investment process. I started showing my partners more deals that I found interesting and doing loads of analysis on the future of markets I thought were ripe for disruption.

I have always believed that TV was ripe for disruption. The parallels to the music industry are too obvious even though the industry players, the medium and the cost structures are different. US TV advertising is $60 billion in its own right. I had found my industry and a deal I really liked in it.

I introduced my partners, we spent weeks with the team and felt good rapport. And just when I thought I had the deal that was worthy of bringing to investment committee the world changed. It was September 2008. The market had tanked. Lehman Brothers had filed for bankruptcy. It was many events that led to the crash but perhaps this was the pin that pricked the market.

The following is a 2-week graph of the end-of-week price of the Dow Jones Industrial Average (DJIA) in Autumn 2008.

And while the market was off 24% in two weeks, it’s worth remember 2 other things

• The market was actually off 40% from its Oct ’07 peak
• The market wouldn’t bottom until Mar ’09. On Mar-6 it hit 6,626 or 53% off its peak

We thought the following:

• No new deals close until we figure out WTF is going on with the market. We need some visibility.
• Let’s review all of our existing investments. Let’s make sure each has enough cash. Cut where needed. Finance where needed. Anyone not going to make it?
• Who has deals in process? Let’s help get their funding get finalized or the company sold if it’s already in play.
• Fawk, man. This is really bad. Depressing. Harrumph.

It felt awful. Kind of like you felt as personal investors, no doubt.

My deal got dragged out and eventually never happened. Mostly we got to see the team operate in stressful times and that changed my perspective on the deal. I need leaders who manage in good times and bad.To build a large company you need to manage through economic cycles.

2009

Come 2009 we felt really bullish about the future for startups because the froth was gone and so, too, were wantrapreneurs. The people left standing had a compelling vision to build companies and we backed many in 2009.

When this period was fresh, in Sept 2009, I wrote a very detailed assessment of what I thought had just happened.

tl;dr summary

• Companies raised too much money in 2005-08 and had high burn rates
• VCs were very active in this period
• When the market tanked they had the “triage problem” – which portfolio companies to save, which to kill
• So no new deals got done. Everybody focused inwardly
• And VCs scrambled to raise their own funds. Making even less time for new deals
• VCs hate downrounds to even good companies struggled to raise money

The full articles are linked below. If you want a comprehensive summary of the industry in this era it’s worth a read:

VC Ice Age Part 1 – What Happens When a Market Comes to a Standstill?
VC Ice Age Part 2 – Why the Market Started Moving Again?
VC Ice Age Part 3 – What The Future Holds

In particular part three talked about what happened if we saw a double dip in 2010-11 or a “lost decade.”

2010

We did not. Fundings boomed. 2010 was the year of the “super angel” and 2011 has to date been the year of unbelievably highly priced B,C & D rounds of venture capital. The so-called “billion dollar club.”

Fast forward a year to September 2010 and I wrote my treatise on the 2010 economy. It has some detailed charts you may appreciate if you’re wanting to understand the current economic situation. I show charts on housing, structural unemployment, home equity re-financings that we spent meaning less spending power post crash, new housing sales, debt-to-income ratios, public-sector job problems that will cause crises in cities and states across the US.

Summary version? No chart was good.

At least you can’t accuse me of being inconsistent. My year-over-year summary sounds very similar upon re-reading them.

2011

I have a young entrepreneur friend who IMs me a lot. He was working on a VC round in the early Summer. He pinged me for advice. I told him (verbatim), “close your round by August 2nd. After that, all bets are off.” He’s literally on IM right now in my other browser tab saying, “you called it.” I can’t say his name yet because he hasn’t announced funding. But he got it done. Maybe he’ll reveal our conversation when he announced.

August 2011. What’s happening?

The fundamentals in our economy are mostly not on more solid footing than when I wrote the posts in 2009 and 2010. On the positive side, corporate profits are up, their balance sheets have been repaired and they have recapitalized themselves to have lower amounts of debt relative to equity. Not just tech companies but industrials, too.

But you’d have to be a pretty heads-down coder to not have noticed the past 2+ weeks in the DJIA.

Most of the informed people I know are telling me that the sharp sell-off has more to do with European national debt (PIGS as it is called: Portugal, Italy, Greece & Spain) than the current US dilemma of a S&P downgrade of the US government debt. But it must also be on the minds of investors that perhaps the flu will end up on our shores, too.

I know that investors must also be aware of the civil unrest in the UK. Yes, it seems to largely be thugs. But social unrest is created in harsh economic times and we’ve seen this in Greece before. Expect it to spread. It does weigh on the mind.

And while I cannot tell you for sure what was going on in VC partner meetings across the world today – I’m a data point of exactly one – I think I have a pretty informed guess. And depending on which way that economy heads I can tell you what the story in entrepreneur land *might* be in 60 days, “funding is getting harder, valuations are slipping, companies are running out of cash, M&A is slowing down.”

So let me give you the news 2 months early. If the economy and the stock market continue to languish that’s exactly what’s going to happen.

I’ll bet most partners’ meetings this week consisted of looking just a little bit closer at the cash needs of their portfolio companies – making sure they’re “fully funded.” I’ll bet many of them did a review of their “investment pace” as in – how quickly should we be investing. I’ll bet many did a slow roll on deals that might have gotten approved today. Not a “no” but not yet a “yes.”

It’s impossible to sit in a partners’ meeting on a day like today without having an iPhone on watching the stock market free fall and no matter how much of a public tech cheerleader you are – privately I guarantee there was much concern.

If we do head South it will take a few weeks or months until the memos to portfolio companies get published and the Powerpoint presentations get sent out. But the internal conversation started today – trust me. VCs will take a “wait and see” approach right now. Don’t want to call it either way. It’s too early.

Me? I feel confident telling you to, “Watch your pennies. Raise your money. Don’t spend like it’s 1999. If we’re not heading for a double dip recession at least you’re still being prudent.”

Maybe we’ll bounce right back? Anybody who says they know for sure one way or the other is a bit of a shaman. But I have to imagine the speed and severity of the stock market decline and political instability will likely weigh on investors for some time to come – even if we rebound.

[Update: I wrote this post for TC yesterday. Obviously the market rallied today on news from the Fed. I'll cover this in my next post. Hopefully tomorrow. Here's the graph for the books.]

I’ll tell you what still worries me: Jobs, growth & political malaise. And don’t think tech will remain immune.

I guess that’s why I encouraged people to raise money while the getting’s good (PPT slides & video).

My prognosis?

1. Jobs
I’ve been parroting this for 2 years. We have a two-track economy. We have the inability to hire engineering in Silicon Valley or brand sales people in NYC but the country still has very high structural long-term unemployment. Check out the graph below from the Economist magazine. It plots employment changes from the peak GDP quarter of the previous boom. What you’ll see is that it takes about 2 years to recover jobs from the normal recessions of the past 50 years (as if there was a “normal.”)

This recession?  We’re 2.5 years in and still down 5% from the peak.

What gives? I’m guessing many of these jobs ain’t coming back any time soon. The last big recession was in the early 90′s where IT and globalization were in their infancy in terms of impact. We need a plan to replace these jobs long term. That can only come through education, training and investment in regions of the country that are not IT centers.  There’s no band-aid solution and no quick fix.

Whatever you think about tax policy, I’m certain that it’s not driver one way or the other to fixing this problem. Anyone who says it is a driver is selling you political malarky.

We gotta fix jobs.

2. Growth
The story here is no different.

My message to entrepreneurs has been, “It’s coming soon to a theater near you.” You know – the “butterfly effect” on a local and tangible basis. Consumers hurting in Detroit or Biloxi will not continue to spend money they don’t have and income they’re not earning. It will impact retail. It will impact brands. These companies advertise. On your tech platforms. These consumers buy iPads, iPhones, Androids. You’re counting on them for up-sells to your app. For buying virtual goods. You need consumers – they’re 70% of the economy.

Trouble is – they don’t have jobs. Those that do still have too much debt. Their 401k ain’t what it once was and it just got whacked again. They still have too much personal debt. And the equity in their house isn’t rising. They’re doing what economists call “de-leveraging,” which means spending less, saving more.

And you don’t see it. You don’t see it because the world you likely live in if you’re reading this has been booming. And even if you’re not physically in a booming tech market you’re likely in the market spiritually, metaphorically. You’re reading TechCrunch, aren’t you?

3. Political Malaise
I think here I’ll just quote myself from my analysis a year ago to avoid sounding like I’m jumping on the bandwagon of this week’s quarterback analysis:

“While there was a momentary unity in the US government for bailouts & stimulus spending that were initiated in the Bush administration (many people conveniently forget this now) and continued under Obama, it is clear that this era of consensus is over.  Keynesians will argue that this is a bad thing and fiscal conservatives will argue that it is a necessary discipline. 

Either way, the gridlock that is now the US congress will prevent any real economic responses and it seems likely that this political malaise will last beyond the 2012 election as the Republicans look to make big gains in the 2010 mid-term elections.”

Maybe the stock market drop will bring some clarity to congress. Maybe it will bring some bi-partisan spirit to solving the nations problems. Maybe. But evidence seems to the contrary. Right now people seem to be angling more around November 2012. And that sure sounds a long way away to me.

What does this mean for the tech and VC markets?

I’m characteristically still bullish on our long-term trends for companies who get through the toughest times. Here’s what I know:

• Television will be consumed dramatically differently in 10 years from now than it is today. Creative destruction will continue to create opportunities for people who understand the deflationary economics of the Internet. I’m long.
• Cash will continue to become less relevant in 10 years as electronic & mobile commerce continue to proliferate and new technologies like NFC drive change. I’m long on payment technologies.
• Computing will be an order of magnitude more mobile 10 years from now, changing the way applications are delivered and the way we interact with our real social networks. I’m long Mobile. And Social.
• Businesses will continue to realize that the Internet is one big information utility and will continue to move operations to the cloud. This will create whole new segments of the tech market for databases, data-as-a-service, real-time information processing, cloud mapping & visualization technology, etc. I’m long the cloud.

Venture capital is an industry best served up from 7-year aged casks. As many people have said, “We over-estimate the impact of technology in 3 years and under-estimate the impact in 10 years.”

Make sure you’re still here in 10 years. Get yours. Then go build your companies.

Top image courtesy of Fotolia.

Today I’m announcing that GRP Partners is doubling down on the Twitter ecosystem by investing in DataSift, a company who provides a real-time data platform and tools to third-party developers and corporations.

Our goal is to make the enormous volume of real-time information more manageable for the 99% of companies that lack the infrastructure to process these volumes in real time. Think of DataSift as turning the fire-hose into a cost-effective and manageable tap of running water. Or in utility speak, they are transmission and we are last-mile distribution.

And better yet, the company has a product that will turn the stream into a lake. What does that mean? The Twitter stream like most others is ephemeral. If you don’t bottle it as it passes by you it’s gone. DataSift has a product that builds a permanent database for you of just the information you want to capture.

Finally, DataSift has an enormous about of historical data already stored we we can help you go back and retrieve some older data for analytical purposes.

We’re co-leading the $6 million investment with Roger Ehrenberg at IA Ventures in NY and one of the most respected early-stage investors in the country in “big data” companies. As a former hedge fund guy, Roger immediately saw the value in helping companies better sift through the masses of data; often to gain better insights into financial information. I couldn’t think of a better partner at DataSift.

GRP Partners has made clear its commitment to big data & cloud services with recent investments in Factual, MongoLab and now DataSift. If you’re interested in a long post on where I see the data layer going you can find it here.

And while DataSift is a provider of multiple real-time data feeds, I would like to be clear that Twitter is by far the most important and dominant of the real-time publicly available data that exists on the Internet today, which is why today’s bet for me is on the Twitter ecosystem.

Some will cite my investment two years ago in social-media advertising company Ad.ly as an example of why I shouldn’t be investing in the Twitter ecosystem any longer. Those people misunderstand Adly, this recent investment and Twitter’s potential.

So with DataSift I’m doubling down.

Twitter as a company has encouraged this by granting DataSift “re-syndication rights,” which means that the company can ingest the full Twitter fire hose and resell subsets of it to other parties who want to consume a smaller stream, which is more cost effective in data licenses and in IT resources needed to consume the data. DataSift is one of only two companies today that has the rights to re-syndicate the way it does.

Twitter knew the importance of providing a long-term contract to DataSift to encourage investment in the company, which they wanted to see.

So let me explain what I see as the importance and sustainability of Twitter as well as why I believe it’s still a great platform for startup companies and investors.

The Importance of Twitter

Twitter’s significance stems from the fact that it is a real time, open, asymmetric, social, viral referral network that is often location aware and provides both explicit and implicit interests and preferences.

Whew. That was a mouthful of buzzwordtopia. But each point is actual and can be explained to avoid hyperbole or other SAT words.

1. Real time – Much has been written about the real-time nature of Twitter’s news. I am one of those that learned about Bin Laden’s death, the Japanese Tsunami, Michael Jackson’s death and many other topics 20 minutes before they were in the mainstream news.

What is less considered is just how valuable the real-time nature of information is. Think about this: The investment banks and trading houses across the globe have invested billions of dollars in computing equipment and staff in order to process news that affects stock prices milliseconds before the rest of the market can process & transact on this same information.

Providing near real-time information to financial traders made Michael Bloomberg a billionaire and helped create the powerhouse Reuters. Real-time information drives commerce.

Real-time information drives decisions about marketing spend on movie releases. Normally studios would have to wait for box office receipts of opening weekend to make these decisions. Twitter data has shown a correlation in predicting box office success a priori.

But the applications are limitless. Consider political campaigns that are judging voter reactions or the political pundits that like to comment on such data. Or the ability of the Center for Disease Control to be able to track pandemic distribution of viruses. Or just the sheer power of people being able to self organize as they have done in Egypt, Iran or Tunisia.

“In a world where real-time data is exploding, those that can provider synthesis, insights & structure out of information will have an edge.”

That is what I Tweeted when I saw DataSift present as a finalist at TC Disrupt last year. DataSift will be one of the major platforms to enable these real-time insights because without reducing the dataflow and without tools to interpret the data most companies will just be staring at data.

While Twitter is not the only source of real time data today it is the largest and most important.

Why?

2. Open – Twitter made a decision from inception that it was intending to be an “open network” – the information you post there is publicly available. When we starting using the product we knew the rules so everybody (except maybe Anthony Weiner) understood that they should only provide data that they didn’t mind being read publicly.

This turns out to be one of the real differentiators for Twitter. While Facebook currently has more users and more engagement, much of this data is behind a firewall and therefore only useful in so much as Facebook can serve ads against it or get people to spend money there. Facebook continues to try and convince people to make more data publicly available. But that’s not the deal they made with us when we signed up.

So while Facebook has other advantages, Twitter is in the driver’s seat for valuable data that can be openly interpreted and acted upon in business.

Perhaps the least understood advantage comes from Twitter’s follower model, which is asymmetric.

3. Asymmetric – Before Twitter most social networks had “symmetric” relationships meaning that when somebody wanted to follow you, you had to follow them back in order for us to be connected.

Not so on Twitter. People can follow me and I don’t have to follow them back. I have about 40,000 people who follow me while I only follow 700. It’s normal to expect that anybody with a large following wouldn’t follow everybody back. If I followed 40,000 people I’d never see the information that I wanted by the people from whom I most wanted to hear.

And of course in my 700 are people like Bill Gates and Barack Obama, neither of whom follows me just yet Asymmetric works both ways.

So what is now happening is really interesting. First, you’re noticing that TV journalists and news shows are listing their Twitter handle and saying “you can send messages to @anchorman.” Our Twitter handle has become our identity, on par with an email address. This is becoming more popular with individuals than telling people your Facebook page, which unless it’s a “fan page” requires them to follow you back.

But asymmetry provides another very important thing: it expresses my interests. If you were to run an analysis on me you’d find that I tend to follow a number of people in the VC industry as well as tech professionals. You’d find out that I’m more interested in getting my news from the BBC or NYTimes than from other sources, which I’m sure would tell marketers something.

The asymmetric follower model where we also follow news, celebrities and senior executives at companies is one of the reasons people often refer to this as an “interest graph” because it is an expression of what I care about.

4. Social – Asymmetry is one of the big drivers of Twitter. But one of the other major factors in Twitter is the fact that it is also “social” in that people have conversations with their peers and friends.

This is another obvious source for business intelligence. You can learn a lot about who are my real friends or business associates by how often I retweet them or send @ messages. Companies like Klout already use this information to determine who has influence. Or as founder Joe Fernandez recently told me, “we’re building the ‘PageRank’ for people.” They have focused much of their initial work on Twitter data.

Ad.ly is already providing these kinds of insights to the celebrities that use its system including Serena Williams, Paris Hilton, Linkin Park and, of course, Kim Kardashian (with her 8.2 million followers).

Ad.ly has now made these analytics available to the public. Here’s some examples you can infer from the social data:

@SnoopDogg has more Twitter fans in Texas than he has in New York.
@ParisHilton shares 1.7 million fans in common with @KimKardashian, but has more than 2.1 million fans in common with @BritneySpears.
@PaulPierce34 knows that the only people that talk more about him than the Celtics fans do are Lakers fans.

They know this because Twitter is social, open & asymmetric.

5. Viral – One of the most important value drivers of any social network is the degree to which it makes content go viral. In the industry they call this the “viral coefficient.”

Twitter is inherently viral. One of the most common ways that Twitter users try to add value to their followers (other than Tweeting themselves) is to “retweet” other people’s Tweets.

The Retweet IS viral adoptions. And it is part of the psyche of Twitter. So by now everybody know that 30% of all of the Tweets from the first week of July were about Google+. One story is, “Hey, maybe there’s something to this Google+ product?”

The more missed story is, “Holy shit. Twitter is really the place where the public conversation is happening. It is the town hall. It is “Speakers’ Corner.” It’s where Google goes to create real Buzz (I know, I know). It is a must have if you’re building a technology product these days. To not lure in users through “social hooks” of Twitter would be madness.

You all know that Turntable.fm is hot right now. Let’s be clear: its growth and awareness was driven through viral hooks that they pushed out onto Twitter. I kept seeing my friends play this or that in “chillout room” on Turntable.fm.

6. Location Aware – According to Dick Costolo’s statements at CES, up to 40% of all Tweets are sent via mobile devices, which is a hugely powerful asset for Twitter. Many of these Tweets will have information about the user’s location that makes increases the value of the data enormously.

If I Tweet about the Wynn Hotel while I’m in Las Vegas that Tweet has a different value to local business than if I Tweet it from my office in Los Angeles. Real time + location equals marketing opportunity.

And that’s exactly what happened to me last year. I sent out an “open” Tweet saying, “has anybody been to the Wynn Hotel? Is it worth walking across town for?” Aside from the people who chimed in with points of view, the Wynn Hotel offered me free chips if I’d come down and play.

Real time + location + Klout + interpreting my demographic data could = goldmine. How about if they knew how often I came to Vegas? I might be different if I’m there 1x / year versus 1x month.

Twitter = amazing business & marketing engine for companies. DataSift = platform for companies to develop cost-effective applications using this Twitter data to gain advantage relative to their competition.

7. Referral Network – Twitter started as a way to integrate web messaging with text messaging. Since SMS has a maximum length of 160 characters, Twitter decided to limit you to 140 characters so that 20 could be reserved for other things.

While it’s true that the basic service that we know and use today was the exact one that the founders envisioned, one of the most important components of it, “link sharing,” could not have been imagined.

Because Tweets are limited to just 140 characters, users who wanted to talk about other websites had to put in a link as part of their 140 characters. In order to minimize wasted characters we started using “link shorteners,” the most popular by far is Bit.ly.

And from this simple accident came the most powerful driver on Twitter. Because we include links in our Tweets, Twitter has become one of the most powerful sources on the Internet for driving traffic to websites, blogs and news sites.

8. Explicit – Because we can track the open, real-time links you’re sharing we know something about your interests. If you’re sending lots of Tweets about “gay marriage” we can likely ascertain whether you’re for it or against it based on the “explicit” links you’re sharing.

Again, this is made even more powerful by knowing your location. Maybe you’re not even using Twitter on a mobile device but we have enough information about the propensity of people you follow and their locations to determine that you’re likely in New York State.

And imagine we’re an interest group that wants to enlist you to lobby your congressman on our behalf on this topic. Twitter will be the source in the future for political parties finding you and even for communicating with you. You’re simply an @message away from my reaching out and asking for your help in putting pressure on our local congressman.

Every action you take in Twitter: Whom you follow, which links you send, what words you use in your Tweets, any location you give us, whom you retweet, etc. will tell us something about you.

And DataSift will help others companies make sense of this data.

9. Implicit – Do you follow Fox News, Rush Limbaugh, Sean Hannity and Glenn Beck? Well if you also follow Keith Olberman and Rachel Maddow then I can interpret something about you. If you follow the former and not the latter I can interpret something else.

No interpretation will be 100% accurate but companies will run correlation analyses to determine probabilities that you are a, b or c. Even if they’re not using this to target you with information sent via Twitter, they might use it in aggregate to determine things like the likely electoral votes in a region that will swing for a candidate. Or the probability of Southern Democrats to buy cable versus satellite or an Android versus an iPhone.

Companies like LocalResponse are using this implicit data to help merchants offer better targeting to loyal customers and help them figure out whom their customers are in the first place. It is an awesome example of the power of implicit data.

The Twitter Ecosystem for Startups & Investors

When I think ecosystems that are ripe for partnering with I consider the following: will the platform be valuable, is management communicative and committed to third-party developers and does the company have a long-term vision.

Let me quickly take these in turn.

Twitter Provides a Valuable Ecosystem – I’ve already highlighted my views on this topic in the first section. Twitter is a valuable and unique service. Twitter is not replacement for Facebook (or vice versa) and while it is competitive it is mostly competing for: user time, brand dollars and 3rd-party development resources.

In the area of third-party tools Twitter is behind but it has huge network effects and totally unique attributes. I believe this makes Twitter the perfect ecosystem for development.

Twitter’s Original Sin - Twitter was formed from what one of the most famous business thinkers, Henry Mintzberg, called an “emergent strategy.” This basically means that the success of Twitter as we know it today was not planned. As is known now in folklore, it was a side project at the company Odeo.

As a result not enough thought in the early days went into thinking about whether it was a “pure platform” that was independent of how its data would be consumed or whether it wanted to build an end-to-end system while still making its data available for third-party integration.

So it fostered a community of “try anything you want” developers and many people did just that. Because the company was under resourced relative to the size of the opportunity and its growth rate, it never had an industry-leading client from which to consume Tweets.

In the computer space you therefore had the emergence of many desktop clients such as TweetDeck, Seesmic, HootSuite and many others. These have all broadened but they all started as pure Twitter clients.

In the mobile space you had leaders for every platform: iPhone, Blackberry & Android: None of these was originally built by Twitter.

So while many articles have been written about the management changes at Twitter and what this means, I would point out that what it means to me as an investor and what you might consider as a developer is that Twitter is open for business.

They recognized and decided that their main business had to be an end-to-end service where they controlled the experience of user consumption. This is important both to maintain a consistent user experience (think the cleanliness of Facebook UI versus that of MySpace where users controlled the UI more) as well as to have advertising be an important part of their economic future.

So they went after controlling the user clients. In my opinion they could have had a smoother communication about how & why they were doing this but I never argued with the logic of what they wanted to achieve.

I point all of this out because I believe it’s the main reason the press still focuses on whether or not they are a good development ecosystem. To understand this you need to look at all of their other moves.

Communications by Management – If anybody might have been worried about Twitter as an ecosystem it would have been me. I made an early investment in its ecosystem by backing Ad.ly. Shortly after announcing that Twitter wanted to control the clients and would start filling in holes in its offering: Photo sharing, link shortening, advertising, etc.

But Twitter’s management team wasn’t hostile. They spelled out their views in their terms-of-service for people to digest. Ryan Sarver who was heading up platform development was active in the developer forum giving guidance to worried third-party developers.

Behind the scenes Dick Costolo was reassuring investors who put money into the ecosystem that he wouldn’t be hostile. He laid out clear areas where Twitter felt it needed uniform standards to control the user experience and made it clear where Twitter wanted to monetize.

No guarantees – just guidance. He even gave some suggestions as to what he believed the market wanted and what areas Twitter currently had no plans to build.

This is all you can ask for as a developer: a communicative management team who wants to foster an ecosystem and who will play fair enough as it changes its own course.

I wrote extensively about this at the time of their first acquisitions, including this passage:

“I saw a lot of this first hand in Salesforce’s acquisition of my company, Koral, which was a content management (CMS) company. Naturally every other content management company was pissed off and felt that they had wasted all of their investment in integration with Salesforce.

Immediately after the acquisition we held meetings with all of the integrated CMS vendors and highlighted to them which bits we were going to make our core platform and which bits we weren’t planning to offer ourselves. We didn’t have the resources to do it all.

Salesforce was very good at managing the 1-year roadmap so at any point in time we had a pretty good idea about what we would be developing and what we wouldn’t. We also knew what we wanted to build but wouldn’t be able to get to.

Importantly, all of this was done privately, as it should be.”

Twitter now has the human resources to deal with its developer community and to outreach to VCs who would back them.

How Does Twitter Stack up to the Rest of the Ecosystem? – I would argue that Twitter has been behaving more like that Salesforce model than many other players in the ecosystem.

Consider Apple: they change their rules of operation at any time and with no notice to third-party developers. Just ask TapJoy who had built a large incentivized download model and woke up one day to find out that Apple prohibited their service.

Every developer who builds on the Apple ecosystem bites their nails waiting for the annual WWDC conference to see whether their company is on the “kill list.” And in typical Apple still they tend to remain very tight-lipped until the day of their announcement.

Or how about Google? They change their search algorithm on a regular basis and as highlighted in John Battelle’s excellent (must read) book ‘The Search’ companies are literally put out of business with each change. And ask any publisher and they’ll tell you that there’s very limited access to the search algorithm team following a release to appeal anything that affects your business. In fact, they seem intentionally opaque.

Facebook? Read this story that is typical of many entrepreneurs with whom I talk. Most wont write stuff publicly because they fear retribution. This story could be written about any major platform, not just Facebook.

Let’s look again at Adly. We contacted a senior official at Facebook about running ads on Facebook Fan Pages where the celebrity had authorized the ad. A senior Facebook official told us, “Great idea. Go Ahead. I can’t put it in writing but I won’t stop it.” He then left the company.

Not long after with no substantive dialog with the company we received a “cease and desist” letter. We wanted to point out that other parties were running similar ads but doing it in a way that was less valuable to Facebook. There was no interest in a discussion. Cease. Desist.

OK. That’s life. We started focusing on how to better work with the platform in ways that would stay within Facebook’s specified terms.

On Platform Development – I point out the Apple, Google & Facebook examples not as criticism but to point out the rules in dealing with platforms. You need to build with multiple platforms in mind because as the rules change you need to have relative strength to adapt.

But most companies get a free pass by the press for their market moves where Twitter has received more scrutiny. In many ways they seem more open to encouraging developers these days.

I think that today’s journalists want a simple story: “Twitter hasn’t yet proved its business model” but I think that misrepresents the long-term value. As an investor and person whose job it is to figure out future value drivers before others, my bet has been on the long-term value of Twitter.

So I’m doubling down on the Twitter ecosystem by investing in DataSift. Like any company I’d advise, we’ll be focused on multiple streams both because our customers demand it and to maintain our stability as an independent company.

But as I stated, Twitter is at the core of today’s service. And I feel great about that.

Blackjack & Apple images courtesy of Fotolia. Michael Bloomberg photo courtesy of ImageCollect.

This is the final part of a 3-part series on the major changes in the structure of the software & the venture capital industries.

The series started here if you want to read from the start.

Or the Cliff Note’s version:

• Open Source & Cloud Computing (led by Amazon) drove down tech startup costs by 90%
• The result was a massive increase in startups & a whole group of new funding sources: both angels & “micro VCs”
• With more competition in early-stage many VCs are investing smaller amounts at earlier stages. Some are going later stage to not miss out on hot deals. I call this “stage drift.”
• The opportunities for tech startups today are more immense than they’ve ever been with billions of people now connected to the Internet nearly all the time.

But …

Downsizing Venture Capital
The venture capital business itself is going through an even more fundamental change than just the entry of a new category at the earliest stage. The industry is shrinking back to a mid-90′s level in terms of both dollars and numbers of firms.

The doubling of the industry size was caused by the euphoria of the dot-com bubble and since funds take 10 years or more to dissolve the bursting of the funding bubble has taken its time. We all know the result of the over-funding of the asset class – poor returns in aggregate for the industry. The best firms have still delivered results, though.

So what’s happening now is the elimination of funds that probably should never existed as well as the questioned relevance of some older firms that failed to find good succession strategies or remain relevant.

That’s certainly good for our industry in terms of future returns for investors but I would argue also for entrepreneurs. In the last 90′s it was impossible to charge fair prices for products & services in a market where you had 5 competitors giving away free products to acquire “eyeballs” and fueled by an excess of venture capital.

A normalization of the venture capital market will bring more rational valuations over time but should produce more stable companies and better returns for VCs and LPs. It doesn’t feel like that now because we’ve entered a mini bubble in pre IPO valuations for a segment of the tech market but this, too, shall pass.

The Coming Brick Wall
What I’ve started to observe is that we’re certainly headed for a bit of a brick wall for early-stage companies. The explosion in number of startups coupled with the decrease in numbers & dollars of VCs portends this.

As an industry this is probably OK. Creative destruction is what drives capitalism and innovation. Some startups won’t make the cut but those founders will have developed invaluable skills and will join the ranks of the survivors. I’m proud to see this creative destruction happening more prevalently in the US right now because it gives me comfort that we haven’t lost our footing in terms of global innovation.

I would argue that the explosion in startups and the coming brick wall will continue to create compelling opportunities for venture capitalists. As an industry we have more startups feeding into the top end of our funnels from which to evaluate and choose the most prudent investments. The coming brick wall will ensure that valuations reach their natural limitations and return to normalcy. The coming brick wall will produce more second-time entrepreneurs whom we can fund that will bring real experience to the table in their next businesses.

I know that a brick wall is a rather nasty metaphor, but it’s not all bad. Like any market that overheats we will have the negative collateral damage but also the blossoming of the next wave of innovation and returns.

Borders, Normalization & The Continued Relevance of Venture Capital
My prediction for what comes beyond the brick wall?

• Continued high pace of startup innovation. The lower costs & lower barriers to entry support this. Also break-out companies like Rovio and NewToy that grew big without much capital will continue to encourage young entrepreneurs to try
• Increased reluctance of angel investors to fund any new hot team based solely on the “social proof” of who else invested. Brick wall = lost money for early-stage capital primarily concentrated on angels. I’ve been on-record here for a while.
• Return to focused strategy for investors where Micro VCs have a more established position in their market and traditional early-stage VCs become more comfortable waiting for products to be completed as FOMO (fear of missing out) subsides
• Hedge funds and growth equity firms returning to their traditional segments of the market

Basically, I believe that each market participant brings strengths relevant to their stage and I don’t believe in huge stage drift. The software industry is changed for good and the next decade will truly be dominated by the open cloud and open platform companies that embrace this. And the IT segment of the Venture Capital industry will continue to evolve to meet the market needs, not vice-versa.

Brick image courtesy of Fotolia.

In this three-part series I will explore the ways that the Venture Capital industry has changed over the past 5 years that I would argue are a direct result of changes in the software industry, not the other way around. Specifically, Amazon has changed our entire industry in profound ways often not attributed strongly enough to them.

I believe the changes to the industry will be lasting rather than temporal change. Venture capital is in the process of its own creative destruction with new market entrants and new models of innovation at the precise moment that our industry itself is contracting.

I will argue that when the dust settles, although we will have fewer firms, each type well end up more focused on traditional stage segments that cater to the core competencies of that firm. The trend of funding anything from the first $25k to funding $50 million at a billion+ valuation is unlikely to last as the skills and style to be effective at all stages are diverse enough to warrant focus.

I will argue that LPs who invest in VC funds will also need to adjust a bit as well.

Rewind
When I built my first company starting in 1999 it cost $2.5 million in infrastructure just to get started and another $2.5 million in team costs to code, launch, manage, market & sell our software. So it’s unsurprising that typical “A rounds” of venture capital were $5-10 million. We had to buy Oracle database licenses, UNIX servers, a Sun Solaris operating system, web servers, load balancers, EMC storage, disk mirrors for redundancy and had to commit to a year-long hosting agreement at places such as Exodus.

Open-Source Software & Horizontal Computing
The first major change in our industry was imperceptible to us as an industry. It was driven by the introduction of open-source software, most notably what was called the LAMP stack. Linux (instead of UNIX), Apache (web server software), MySQL (instead of Oracle) and PHP. Of course there were variants – we preferred PostGres to MySQL and many people used other programming languages than PHP.

Open source became a movement – a mentality. Suddenly infrastructure software was nearly free. We paid 10% of the normal costs for the software and that money was for software support. A 90% disruption in cost spawns innovation – believe me.

We also benefitted economically from a move to “horizontal computing.” What this meant was that rather than buying really expensive UNIX servers (and multiple machines in order to handle redundancy) we could buy cheap, replaceable servers for compute resources.

As our needs grew we could just add more cheap boxes and as boxes failed we could just chuck them out. We had to learn how to be better at “load balancing & replication” – meaning how we managed data across all the boxes since they weren’t centralized on one box.

These two trends had a major impact on the computing industry from 2000-2005 but the effects weren’t yet felt by the VC industry.

The Emergence of “Open Cloud” Infrastructure
The biggest change in the software industry beyond open-source was “open cloud.”

When we talk about cloud computing we have to be careful to differentiate between open cloud (services the are provided solely to for the economic purpose of building a cloud business) and the “platform cloud” where certain service providers offer cloud services wrapped around their core product. These are very different.

Platform cloud players like Salesforce.com provide compute resources so that third parties can build applications that integrate with its core product. That’s awesome for users of Salesforce.com or companies that want to cater to them but less awesome for pure startups that want independence and are really just looking for cloud infrastructure. Facebook is a “platform cloud” provider, too. That makes both of these amazing companies great channels for startups.

True that Salesforce.com in particular has made interesting moves toward open-cloud services by purchasing Heroku and also launching Database.com. It seems if anybody wants to move more toward open it will be Salesforce.

But for now when you want to build an independent, high-growth, VC-backed startup you need to build your overall company on a truly open cloud.

Enter Amazon.

They came from a different perspective. They have the mass retailer mentality of “stack ‘em high and sell ‘em cheap.” They started by offering cloud storage (S3) on a super cheap, pay-as-you consume basis. Every startup I knew in 2005 (when I started my second company) was using this. Why would we commit hundreds of thousands to EMC before we knew whether we had a big business?

They then launched processing capabilities (EC2) and we startups suddenly didn’t need to buy production servers. Then they launched a simple database, management tools and so on. Amazon will surely keep moving up the stack. My bet is that they fold A9 (their search tool) into AWS and offer search-as-a-service, too.

It sure would put pressure on Google if they had Facebook competing on one side of them for share of users’ time and Amazon flanking them on the other side by providing search to every website out there that might threaten AdSense and even Google’s core search business. Who knows?

If you want a deeper understanding of the layers of the cloud , how it is emerging and some of the exciting new players you can read it here.

Amazon changed our industry. This is mind boggling. That little online book company. Not Google. Not Microsoft. Not IBM, HP, Accenture, Cisco, Salesforce.com or anybody else. Amazon. 100% of the credit. And 9 years after they launched AWS there are still no credible competitors.

I find this strange. And maddening.

That said, Amazon – through AWS – even without strong competition is as wonderful an experience as Amazon the eCommerce retailer feels to you as an online shopper. Jeff Bezos simply deserves to be held up with Steve Jobs as two of the most important people driving innovation in computing today.

Spawning of Micro VCs
The biggest media attention in our industry went to the so-called “super angels” during the 2009/10 timeframe and while I don’t believe there is such thing as a super angel I believe that much media attention was deserved.

The earliest people that I spoke to who understood the changes in our industry were True Ventures & First Round Capital. They built industrial-scale funds dedicated to backing early-stage startups with $500k rather than $5 million. They knew the venture math that if only 50 companies / year are sold North of $100 million the entry price for their investments mattered. These funds were active back in 2006 when I was raising money for my second company. As were individuals like Jeff Clavier with SoftTech VC who was also way ahead of the market in spotting this trend.

More recently great funds like IA Ventures, Floodgate, Rincon Ventures, Founder Collective, Freestyle Capital and others have raised money to focus on early-stage investing as a strategy. And many more individuals that I respect are switching from investing as individuals to fund structures to invest in this category like Aydin Senkut (Felicis Ventures), John Frankel (ff Venture Capital), Manu Kumar (K9 Ventures), Chris Sacca (lowercase capital), Dave McClure (500 Startups) and many more.

I have called the creation of Micro VC as the most important change in our industry and I believe it. These people understand that the nature of startups have changed. They have increased the number of investments, they understand that outdated board meeting formats are too slow & unresponsive, they have designed founder-friendly term sheets that can be executed cheaply and they are allowing for a massive increase in the rate of new startup innovation. At least in the consumer & business web.

The larger ones also do more to hold CEO summits, create recruiting databases, set up email distribution lists, create pools of stock options that can be shared across companies, etc.

I still think it was Amazon that created this category not the other way around. Where open-source computing gave us a 90% reduction in our software, Amazon gave us a 90% reduction in our total operating costs. Amazon allowed 22-year-old tech developers to launch companies without even raising capital. Amazon sped up the pace of innovation because in addition to not having to raise capital to start I also didn’t need to wait for hosting to be set up, servers to arrive, software to be provisioned.

Amazon.

I know I’m going on-and-on. I’m not a shareholder. I’m just in awe of what they’ve enabled and baffled that the media doesn’t give this more focus.

In the next post I explore how the changes initiated by Amazon and then propagated by Micro VCs has led to a blurring of the lines in which stages VCs & later-stage investment firms traditionally invest and why this is driving up valuations in private companies beyond common sense.

This post originally ran on TechCrunch.

I recently spoke at the Founder Showcase at the request of Adeo Ressi.  I asked what the audience most needed to hear.

He said, “They need an unbiased view of the fund raising environment because there is too much misinformation and everything seems to be changing fast.”

This was an audience of mostly first-time entrepreneurs. They have seen one side of a market where many of us have seen the ebb and flow multiple times. Still, market amnesia by ordinarily rational actors always surprises me.

I spoke about a lot of things during the keynote. If you are interested the Vimeo is here. I spoke about whom to raise capital from (funding options), how much I thought they should consider raising (18-24 months), how fast they should spend it (lean until product/market fit, then fat when they’re ready to scale), how fast they should raise it (now, now, now) and at what valuation (at a fair price that I call “the top end of normal“).

I spoke about how Amazon Web Services deserves far more credit for the last 5 years of innovation than it gets credit for and how I believe they spawned the micro-VC category. I said that I felt that Micro-VCs were the most important change in our industry. I believe that. It is great for entrepreneurs and great for VCs.  I will write more about this in the next 2 weeks.

I also spoke about why I believe we’re in a “localized” bubble. I suppose I should have imagined that this line would get more press than all other comments combined. Fair enough.

But a certain amount gets lost in the headlines – especially when not everybody actually heard the video and knows the nuance of the message.

So here is what I have been telling entrepreneurs privately for the past 6 months.

1. Why I believe we’re in a bubble
People get too worked up over the word. I’m no great scholar on bubbles – I have more interesting things to spend my time worrying about than the exact definition, but having been around a few I have at least given them intellectual consideration. I know that most people who are close to them tend to deny their existence, as we saw in the great housing bubble of 2002-2007 and the dot com bubble of 1997-2000.

I believe a bubble occurs when a market is willing to pay greater than intrinsic value for an asset class. That asset class need not represent the broader market. As any historian of bubbles will tell you – there were periods of bubbles in assets as arcane as tulips, South American trading companies, dot-com bubbles & housing bubbles. They are often bound by geographies and asset classes. But they also often have a rippling effect on broader markets as all of our economies seem to be intertwined these days. I said that at the Founder Showcase, too.

The fact that today’s Internet bubble does not represent all companies does not disprove its existence.

Ah, but today’s Internet companies have real revenue! and profits! Sure, that makes them better companies than those of 12 years ago. But that doesn’t mean that people are paying rational prices as investors based on intrinsic value. Rational people can disagree and some may argue that today’s prices are rational and under-pinned by economic drivers. That’s fine. It’s just not my judgment based on the data I see.

In the past I have publicly commented on some specific companies that seemed over valued. Responses ranged from, “hey, they’re in a HUGE market” to “it is an amazing company and their technology rocks.” Sure. But everything has intrinsic value. And you may choose to overpay hoping that the future value will be worth your while. That doesn’t mean it’s not a bubble. It’s like people arguing that there’s a beautiful beach house in 2006 that represents great long-term value due to scarcity of similar property. All of that might be true, but the 2006 price might still be over-valued

What I believe is happening is that private-market investors are getting ahead of themselves for fear of FOMO: fear of missing out. If you are an early investor in Facebook, Twitter, Zynga, Tumblr, GroupOn, LivingSocial, etc. – you’re very well positioned as a fund. I guess that makes USV, Spark Capital, Foundry Group, Accel, Benchmark, Revolution (along with several others) pretty happy right now. And well they should be.

But this mania to not miss out on the next big thing is driving some investors to pay growth-equity prices for traditional market risk (as in, they’re paying up before it is clear there is product / market fit). And so on down then line.

In addition to FOMO it is partly driven by massive increase in valuations for earlier-stage companies who raised money at bit seed prices but who still have product risk. If a company that would traditionally raise $500k at a $3.5 million pre-money valuation is now raising $1 million at a $12 million valuation the next investor has nowhere to go but up (or sit out the investment). Just because the valuation in absolute terms isn’t a big difference does not mean that people aren’t paying higher than intrinsic value for these investments.

And this is happening in mezzanine (pre-IPO) deals as well. And post IPO deals, although these tend to correct more quickly.

Why does all this matter?

2. There are fewer big deals than people imagine
If everybody is over-paying for early-to-mid stage deals you’d imagine that these all need to feed into a frenzied M&A and IPO market that will garner big returns for these risks investors are taking. Perhaps this will trend up massively but historical data doesn’t bode well.

source: Capital IQ

In any given year there are about 50 venture-backed companies or so that are bought for $100 million or more. And for many of these they were (over) funded 7-10 years ago and don’t necessarily all represent great returns for investors or founders. I would guess (I don’t have the data) that less than 5 companies / year are purchased above $100 million that have been funded within 5 years of the being started and have raised less than $10-15 million in capital.

And as you probably guessed the data aren’t any better on IPOs with less than 20 / year average for the past 10 years. Yes, everybody expects a continued uptick given the euphoria of  LinkedIn & Pandora and long anticipated Facebook, Zynga, GroupOn and one day, Twitter. But it’s not enough to justify over-paying for deals.

source: Capital IQ

3. What a bubble means for each entrepreneur
To anybody who asks my advice I repeat the same line, “I don’t know whether this party will last 6 weeks, 6 months or 18 months. But it will end. And when it does the market will shut off immediately. Investors will focus only on protecting existing deals. They will enter the “triage phase” of the market where they figure out which of their existing deals will survive. Many good companies will not get funded. New investors hate down rounds. Vultures will start circling looking for deals. Get funded now, if you can.”

Note: I did not say, “funding is easy” as some people have quoted me. I said, “It’s much easier now than it was in 2008/09.” That’s a fact. And for some it is actually easy. For others it feels like a two-speed economy, where rules apply to hot tech startups that don’t apply elsewhere. Huge structural under-employment in much of the country and full employment in some niche tech markets where it’s impossible to hire developers, designers or sales professionals. You know what I’m talking about. You feel it, too. It’s surreal.

So I’m not advocating panic or a need to rush your funding round. I just think that some entrepreneurs try to “optimize” too much for short-term prices. They hope to delay fund raising (or only raise small amounts now) so that they can raise at a much bigger price later. That may happen.

That’s the problem – you never know when the party’s over. And time is the enemy of all deals so start sooner rather than later, as anybody who was planning to raise in October 2008 will tell you.

And for some that means that despite waiting they may see worse valuations in the future than now. Or worse yet they may never get financed. That happened a lot in 2002 and again in 2008.

I tell people to raise money when you can, but don’t ramp up your spending in a crazy way afterward. Have a cushion. Raise at “the top end of normal” but not so high that future financings in a corrected market become impossible.

4. Bubbles are inevitable
I guess it’s an inevitable process that we seem to go through where markets heat up, get euphoric & irrational and then external market drivers remind us all at once that we were being irrational as a market. We go through our “Bear Stearns moment.” I learned long ago at the University of Chicago where I got my MBA that investors tend to want to invest when markets become over-valued and sell when they become undervalued. Exactly the opposite of what a rational investment strategy would advise.

Why?

In a booming market your investment is worth more than you paid almost instantly. You come in at a $10 million price and somebody else invests at $50 million 6 months later. Feels good.

In contrast, when the market is falling, by definition your investment is worth less THE DAY AFTER you have invested. In a public market this is measured immediately. You are “catching a falling knife.” You have to have patience, which is hard when you see red. So people sell or at least don’t invest.

Some people argue that we’re not in a bubble because the prices are not as crazy or as inflated as they were in the late 90′s. That may be. It may also be that this lasts another 18 months. But when it’s all over and they define the era of this mini run up in stock prices I suspect they’ll include 2011 in the “over valued” category.

5. Good things may come out of bubbles
Bubbles are not all bad. There are great societal benefits that sometimes come out of bubbles. One example is that the telecom bubble of the late 90′s left both the US and the international markets with a greatly expanded footprint of fiber-optic cables laid at the expense of many an over-zealous investor and entrepreneur. I can’t argue that this is better than slow, rational growth. I only point out that there are side benefits of the bursts of energy, enthusiasm and investment dollars.

And the bursting of bubbles isn’t bad for everybody. Those with strong business models suddenly stand out when the tide goes out. An obvious example is Google who may have gotten less market attention if there would have been 8 well-financed competitors during the 2001-2005 timeframe. Or Salesforce.com who rose to prominence in this same period where they were ramping up PR and shouting from mountain tops when everybody else in the market was mute.

6. Why the bad side of bubbles affects entrepreneurs & investors alike
Another misconception of bubbles is that they only hurt investors. That’s not true. When you’re building a startup and can’t hire the engineers you need, can’t retain staff, can’t get press coverage and can’t hire sales people – it certainly affects you. When your competition does irrational things to grow fueled by low-cost capital it makes it harder for you to compete by playing by the conventional rules.

I remember in the late 90′s trying to charge fair prices for software when my well-financed competitors were giving things away for free.

7. Why the bursting of bubbles also affects more than investors
I also point out that bursting of bubbles also affects us all. Sometimes callous observers say, “Who cares if some VCs lose money in a bubble?”

Um …

• many people also lose their jobs when bubbles burst
• some founders lose their life savings
• people who poured their hearts into projects see their efforts vanish over night
• customers who paid for services often get burned
• many ancillary businesses (legal, real estate, services) are affected
• and those VCs are actually investing money from places like state pension funds & university endowments

Trust me, we’re all hurt when bubbles burst. Just think about how you felt the impact of the real estate bust even if you didn’t own property or if you bought well before 2006/07. This market will be the same.

8. The road ahead

I’m not an alarmist person, I’m rational. The sky isn’t falling. There are many things to be encouraged about.

I see opportunities for disruption all around me and am meeting amazingly talented entrepreneurs. I’m looking for ones that understand that in order to build huge, meaningful companies they’ll need to likely build through these boom years and some lean ones. When I find people like that it’s great chemistry.

When I look at the headwinds we face as a country and as a society they are also big. This concerns me about the growth rates we can anticipate for the next 5 years.

I’ve wrote about this 9 months ago. If you want a more detailed analysis see that post. Nothing has changed in my mind since then but it does go to show how difficult it can be to predict the timing of economic impacts. In economics we call these “exogenous events” and if they happen (Greek debt crisis, problems raising the US debt ceiling, trouble in Saudi Arabia) – you will not be shielded.

That said, for every set of global challenges there are entrepreneurs dreaming of solutions, solving big problems and ready to lead us into the next 20 years. It’s what I love about entrepreneurship and about venture capital. We get the opportunity to serve these amazing talents that hold our futures in their hands & minds.

9. Why I will still be investing
I know prices are higher than the norm right now. I am confident they will be lower at some point on a relative basis. But as an investor you cannot simply sit out period of great innovation. As Fred Wilson once pointed out to me, he invested in both Twitter & Tumblr during a high-valuation period.

So at GRP Partners we’re very active now. We’re just conscious to invest in realistic entrepreneurs who know that it will take years of hard work, who are committed to building large businesses over time, who have exceptional skills & passionate about the disruption they’re causing and who are cost-conscious enough to be around for the long haul. Building billion-dollar businesses requires 7-10 years which means operating through at least one full economic cycle, if not two.

We may invest at the “top end of normal” but not at such a high price that we create future problems. We’re not cheap, but we’re disciplined. We are definitely still open for business.

Bubble image courtesy of Fotolia.

I had the privilege of keynoting at the Founder Showcase tonight in San Francisco.

Adeo asked me to speak about fund raising. I generally don’t like to speak about fund raising in a frothy market. If you’re bullish you seem like a Cramer-esque cheerleader and if you’re bearish you sound like a party pooper.

But Adeo asked so I obliged. I don’t know whether they shot video. If they do I’ll post it. I think you can get the gist of it from my presentation although some slides don’t quite tell the full story.

Enjoy. See you in the comments section for our debate.

VC Funding in a Frothy Market

This is part of my series on Raising Venture Capital.

I’m sure I’ll spark the ire of some VC’s for saying so, but there is certainly such a thing as black-out days in venture capital.  It’s worth you knowing this so you don’t waste your time.  It’s also very important to understand so that you can properly plan when you raise money.

Let me first tell you the black-out periods and then I’ll explain why.  It is very difficult to raising venture capital between November 15 – January 7th.  It is also very hard to raise VC from July 15 – September 7th.  (you need to have had your first meeting even earlier.)  If you’re thinking about raising VC and have not yet started the process, you’ve probably already missed the boat for 2009.

If you’ve had your first partner meeting but haven’t had the full partner meeting then you had better schedule it for Monday, November 23rd.  Full partner meetings are almost always on Mondays and if it isn’t already booked yet for Monday, November 16th (e.g. this coming Monday) obviously that’s not going to happen.  If your VC is reluctant to schedule the partner meeting by the 23rd it’s a clear signal that they want to wait until the new year (or they aren’t committed to your deal).

So why is Funding Season over for the rest of the year?  The VC process is almost universal in how it works across firms.  You meet an initial person from a firm – an associate, a principal or a partner.  If it’s one of the first two you’ll probably meet a single partner before coming into a full partner meeting where (by definition) all of the partners will be in attendance.

It’s true that some VC’s will work a few days of Thanksgiving week and many will work the first 2 weeks of December.  But the problem is that trying to get enough of the partners to be at a full partners meeting during  Thanksgiving week or in December is very difficult.  Because almost all VC’s know this, many are reluctant to even start the process with you.

The same thing happens beginning in the middle of July.  Many VC partners take 2-3 (4?) weeks off in August.  I know that many VCs also work in August so I’m not making any commentary about work ethics.  But enough take vacation that organizing full partner meetings proves difficult.

Maybe it’s partially because many entrepreneurs are pre-kids and many VC’s are post kids that VCs take off large blocks of time in the Summer?  Who knows – but trust me (regardless of what anyone tells you) it’s a true phenomenon.

Note that Jeff Bussgang says that VC’s work in August and he’s right.  VC’s are never really “off.”  Just like entrepreneurs they take calls from vacations, do board calls, handle company emergencies and urgent financings.  Jeff argues that his firm has done the most deals in August in the 7 years since he’s been a VC.  I’m betting these processes started much earlier and his firm was just finalizing what had been previously agreed during Funding Season.  Maybe I’m wrong but if I am I’m telling you in my experience his firm is the exception.

One carve out to the “Funding Season” rule – if you’re raising money from angels or small VCs (2-3 partners) maybe you can get something done as you don’t have the same scheduling conflicts.

But by and large I encourage entrepreneurs who are raising money to focus on the following time periods to START your process:

- January 6 – May 15th (green zone)

- May 16th – June 30th (yellow zone)

- July 1st – September 7th (red zone)

- September 8th – October 15th (green zone)

- October 16th – October 31st (yellow zone)

- November 1st – January 7th (red zone)

Please don’t shoot the messenger in the comments, I’m just tellin’ it how it is.  And if VC’s are telling you otherwise, when they’re done with your funding documents I’m sure they’ll also tell you, “the check is in the mail.”

UPDATE: As accurately pointed out in the comments, I advocate building relationships with VCs year round.  It is always best to know your VC well before you really need money (in the same way you’d historically want to know your local banker).  My guide to VC relationships if you haven’t read it.

UPDATE 2: Yes, this is US centric.  In Europe funding season is longer into November but much, much shorter in the Summer! (I know, I lived there for 11 years).  Any views on funding season in Asia?

Montgomery & Co Projects Deal Volume to Grow by 167% in Just 2 Years with No End to Growth in Sight

On the third Wednesday of every month I co-chair a meeting called the SoCal VCA (venture capital alliance), which represents participants from all of the top venture capital firms in Southern California as well as prominent members of the Tech Coast Angels (TCA).  We meet to discuss trends in the industry and to find ways to work together to help with SoCal deal syndication – somethings that happens automatically on Sand Hill Road in NorCal due to proximity.

We feature a prominent speaker at every event.  This morning we heard from Jamie Montgomery, CEO of the venerable Montgomery & Co investment bank who is at the heart of what is going on in M&A for venture backed companies.  They do around 7% of the total VC-backed deals in the US per year or just under 40 deals / year on average (present year excluded!)

I have to admit that I was greatly encouraged by Jamie’s outlook for venture backed companies, which if true will be a welcome relief for our industry.  No doubt a tech M&A banker would have a bias to say that the world ahead looks rosy, but however you want to put a spin on the next 2 years I think you’ll find this data very interesting and useful.  Where I add commentary from myself or my fellow VC colleagues from our discussion after Jamie left I’ll put in red.

Summary of Montgomery & Co’s views on the road ahead for tech M&A of venture backed companies:   (the whole presentation is later in the post, which I suggest you look at because it has insightful data.  If you want to download the document I’ve made it available at my favorite document sharing site DocStoc).

1. 2009 has been the worst year for M&A in a decade.  The total number of M&A deals in the US this year is projected to be a paltry 225 transactions relative to more than 450 deals just 2 years ago, which was the norm between 2002-2007, varying only by around 3% per year.  Projected IPOs for 2009 are an embarrassing 10 total deals, down from 86 just 2 years ago (it was 265 in the go-go years of 99-00) but at least up from 6 in 2008.

2. Montgomery expects M&A to rebound to the normal recent levels at 450 deals by 2010.  They have data from surveys they did with corporate development officers (e.g. the people who buy companies) in Q2 of this year of technology & media companies.  Nearly 50% say they will increase their activity levels in 2010 (hallelujah!) with only 19% saying they would decrease levels.  Jamie believes that if he were to poll corporate buyers this month (e.g. Q4) the number of buyers expecting to pick up activity would be greater than 80%. Montgomery believes there will be 50 IPOs in 2010 as there is pent-up supply and a higher risk tolerance amongst institutional public investors harmonizing at 40 deals / year for the 3 years starting in 2011.

Fred Wilson supports Montgomery’s view in this thoughtful post on the return of the tech IPO market.  Bill Gurley of Benchmark Capital hopes IPO’s will pick up in this CNBC Video but stopped short of saying it would for sure.  He thinks demand for IPOs (from buyers) remains high while supply is low because Sarbanes Oxley amongst other things has made less CEOs want to go public.

3. More interestingly Montgomery expect the M&A market to grow to 600 in 2011 and 750 in 2012.  This would be a whopping 233% increase from today’s levels and 66% above the average of the years just preceding the current recession.  The believe several factors will drive this growth:

• VC’s have a supply of companies they need to sell: There is a huge pent-up supply of venture-backed companies.  VCs are typically “closed-end” funds, which means that we are expected to sell our positions in companies within a pre-defined timeframe and return the money to our shareholders.  This time period is usually 10 years (although small extensions are common).  They cite 800 VC-backed companies that are now > 10 years old and this number would more than double to 2,000  within 18 months if M&A doesn’t pick up.

• Strategic investors are looking to consolidate their positions: The top 6 buyers in tech & media account for 27% of all purchases.  And look at this post by Paul Kedrosky showing how much cash Microsoft, Apple & Google have!  With 50% of buyers suggesting in a Q2 survey (possibly 80+% now) they will increase their pace of investment and a further 33% holding flat this argument is for more deals.  

• More IPO filings will drive M&A: There is a truism that the best way to be sold is to register for an IPO.  Buyers tend to come out of the woodworks and realize that it would be easier to buy you as a private company so it’s sort of one last look.  A recent example would be Compuware’s $295 million acquisition of Gomez, a networking monitoring company.

• A secondary market for buying private companies will likely emerge:  The final point we all discussed was a secondary market for acquiring VC positions.  A secondary buyer is someone who buys either specific positions from a VC or buys their whole porfolio.  What drives this is often the need for the VC to return money to its investors due to the end-of-life nature of its fund.  Right now this isn’t robust because the buyers are bottom-feeders (e.g. cheap) but there was a sentiment that some funds will likely be raised in the next 3 years to buy out VC positions at more fair valuations.

What have been your experiences in the past 6 months?  What are your predictions for the road ahead.  Love to hear more views!

M&A Outlook for 2010 / 2011 –

On December 2nd, 2006 I wrote the blog post published later in this post when I was CEO of startup Koral about my experiences in pitching VCs.After my company was acquired by Salesforce.com I was asked to stop blogging and they took over my blog as an asset in the sale of the company.  My blog was wiped out.  I am very grateful to my friend Zoli Erdos for finding this retro posting for me at web.archive.org.

I had kept a personal blog for more than a year and was new at keeping a professional blog.  I had previously raised VC in 1999, 2000, 2001 and 2005.  I had seen many cycles and decided that since I was going to do it all over again I should write about it.  I had really positive experiences such as working with Greg Gretsch at Sigma Partners where he championed us to a partners’ meeting where we sort of got crucified.  They picked apart holes in our strategy and they were right.  We made changes and Greg was a gentleman throughout the process rather than berating us for our performance (it was our first partners’ meeting).

But we also had some negative experiences, too.  Many.  It included some well known firms that made me come for a team pitch and then only gave me literally 15 minutes when we’d scheduled an hour.  It included one firm who I asked  not to call Salesforce.com as a reference (they were our largest pilot customer) and in their kindness they called Marc Benioff (the CEO) and asked his opinion.  Another called Parker Harris, the co-founder and CTO.  In case VC’s haven’t figured this out yet, shit rolls downhill.  And both of these calls got passed down the chain with sufficient “Chinese Whispers” that by the time they got to me my buyers were perturbed.  No prizes for guessing which VCs I didn’t work with (and still won’t).

I decided to write about my experience and to be blunt.  Not only was it in character, but I also knew that nobody was yet reading my blog.  That changed very quickly.  My blog linked to Brad Feld’s blog because I was so grateful for his series on term sheets and he was one of the biggest reasons that as a VC I felt compelled to blog.  Remember, I was new to professional blogging.  I hadn’t thought about the fact that he would become aware of my link.

On December 3rd Brad Feld wrote a one paragraph blog post titled “Raising Venture Capital” in which he linked to my blog.  There was no viral social networking products back then like Twitter where people could easily discover your content.  It seemed that the main discovery mechanism was the “blog roll” that everybody kept.  It was sort of like Twitter’s list of who you follow but much, much smaller.  The only other ways to get discovered was to have good organic search results or to get covered by a major blog site.  And covered we did.  This blog post ended up on Valleywag (which had much bigger presence back then).

It became a huge kerfuffle with many VC partners writing to thank me for the post, which exposed those that gave their industry a bad name.  And then I was mortified – Valleywag figured out which firm had treated me the worst and published their names.  Gasp.  I had intended to talk about how bad the process could become, not to name-and-shame anybody (and The Funded was not yet around).  The managing partner of the firm called me the next day.  At the end of this post I’ll tell you what he said.

The Original Post:

Venture Capital, By Mark Suster (December 2nd, 2006)

Can it really be a month since my last blog posting? Tempus Fugit. Well … I have had many late nights and I really didn’t contemplate writing many blog postings this month because I spent November in this interesting venture capital / fund raising dance involving lots of late night sessions reviewing legal documents, rewriting business plans and preparing for pitches. We have also been very busy with our next release, which is due out by December 11th (but I’ll save that for a different post). And I guess I have a penchant more for longer blog postings than frequent ones.

So for anybody who has been through the funding process before I hope that this will resonate and for those that haven’t I hope it will be interesting. I don’t plan to write the authoritative venture capital blog, just some anecdotes. If you are interested in reading good blogs about venture capital my favorite two are VentureBlog and Feld Thoughts.

Anyway, the starting point for this blog entry is a cartoon I remember reading in the New Yorker. The picture was of a man in a doctors office that was really irritated. There was a clock in the picture that was set to 9:30. The caption showed the man saying sternly to the receptions, “I had an appointment with the doctor at 9 AM” pointing to his watch. The receptionist replied, “Yes, your appointment with the doctor was at 9 AM but his appointment with you isn’t until 10:00!” Thus is venture capital. You have an “hour” to pitch in your first meeting. It is usual for the partners to stroll in 20 minutes after your appointment so at best you have 40. Prepare to give your pitch in 30 including Q&A. Don’t be frazzled … this is just the way it is.

So far at the company I have raised seed funds of $500,000 of which $470,000 is still in the bank so I’m in pretty good shape. We started building the product 18 months ago so we are in better shape than 99% of start-ups. But nonetheless is takes capital to build out a successful enterprise and I’m not sitting on a pile of it myself. Thus begins the venture capital dance.

The first attention we started getting was after we launched the company publicly at Demo on September 25th of this year. A number of VC’s stopped by our booth or watched our demo on the DEMO website and we had about 5 proactive inquiries. After Office 2.0 we had about 25 firms contacting us – more than I could manage. The first VC I met with came from attending DEMO.  A gentleman had stopped by our booth multiple times and then wrote me immediately after the conference and said that I “HAD to come and meet with his partners the very next week.” Okay. Sure.

I arrived at 12:50 PM in the afternoon, 10 minutes before my start time. I have raised capital 3 times before so I knew the drill. I set up my laptop, connected to the Internet, opened the compulsory 15 page PowerPoint deck and waited for my adoring fans. 1:20 and they turned up like clockwork. Only the thing is, only 2 of the 4 partners showed – we were waiting for the other 2. So I did what one does in this situation – I made polite small talk. I wasn’t feeling it. They looked nervous at having to speak with me impromptu and without the benefit of financial figures to scoff at, product pitches that they’ve seen 100 times and a market sizing to unpick. I’m not trying to imply that all VC’s are socially inept – that’s not the case. But these two certainly were. It got worse.

The third member of the meeting showed up and they sure looked relieved. We all sat down but still had to wait for the fourth. I broke the silence, “so, where do you guys live? Is it a long drive into the City (San Francisco) for you?” They answered politely but behind their words they were thinking, “what kind of idiotic question is that?” as they awkwardly answered that “it wasn’t too bad driving up from Palo Alto every day if one leaves at the right time.” Then, just in the nick of time, 30 minutes past the hour, the straggler turned up. So I was back in the business of pitching to VC’s – a bit like riding a bike I guess.

I started by trying to think I could explain my concept without having to patronize everybody with artificial PowerPoint slides. I thought, what would I do if I was trying to sell to a customer. My plan: verbal 5 minutes to explain the business then straight to product demo where I could cover all of the concepts that would have been in my 2-by-2 charts in my deck. Doh! Dare I steer off the course from the tried-and-true PowerPoint ritual? This approach generally works well with customers because I find it much easier to build rapport when we talk like humans than when we all stare at the PowerPoint slides being projected on the wall.

I was immediately reminded that they were interested in seeing the slides as the main partner who had courted me at DEMO in San Diego shuffled nervously through the print outs of the slides I had sent him in advance. All I kept thinking was, “if you made me send the slides in advance then why the fuck am I now going to spend 10 minutes talking you through them?” I was wrong. “Slides, please.” Okay. This is going well.

Page 1: Market Size. $3 billion industry. Not well penetrated. We’re set to change it. Here’s why those who came before us did not succeed. Man in back of room (the plonker who was 30 minutes late) is now on his Blackberry. No joke. Late and not even the courtesy to listen to me. The partner who said we “must meet this week” is shuffling through his papers and not listening to me either. Partner 3 is listening intently and partner 4 is looking patronizingly at me waiting for the killer question about how on Earth I was going to beat Microsoft.

Page 2: What’s unique about Koral. Experienced and serial entrepreneurs in the content management space. Folksonomy. Consumer approach to software for business users. Viral. Free product. Web service architecture that provides a content management platform for the Internet. Distributed version control model – first in the industry like ours and we are filing patents.

Page 3: Competition. Page 4: Business Model. Page 5: Financials. Page 6: We already have several pilot customers including a very large, unnamed software firm.

Aren’t they tired of this ritual? Well, in this company’s case, yes. Blackberry man is probably asking his girlfriend where to meet for dinner. Gotta-meet-me man is thinking about some other deal. Condescending man keeps jumping in with curveball questions so I am not able to get into the flow. Intent man works for the wrong company. MAN … get out of there!!! Don’t you guys want to see the product?

I start in with the product. Intent man and condescending man love it. We start getting on famously. They are engaged in a beautiful dialog about market adoption and why they have problems managing their documents since they store everything in Outlook. Then, with as much attention as my 3.5 year old son, they promptly tell me that they have another call and leave the meeting at 10:50. Sorry. Couldn’t be helped.

So I’m stuck with the paper shuffler and the Blackberry man. I am not kidding you when I say that I was on the verge of literally saying, “let’s just call this meeting a day. It’s clear you have no respect for me and no interest in my company.” I bit my tongue (which my wife will tell you is rare). I finished the next 15 painful minutes and said goodbye. My only regret … the $25 I had to pay to park in their building. They were seriously the most pompous, self-centered, unprofessional group of people that I have come across in a long time. I went to back to their website and unsurprisingly there were no great companies I had ever heard of. I later learned that they were a spin out from an investment bank. It all made sense. They were not “real” VCs.

Well I am happy to report that it was mostly smooth sailing from there. While I did have many more circumstances that I found frustrating (one firm showed up 35 minutes, apologized because they were trying to vote on whether to fund another deal and then a partner turned up 25 minutes later and kicked us out of the room because he had a conference call) in general I found the process very rewarding. We received a lot of positive accolades on our vision and our product. I visited 14 VC’s, got 8 call-backs for second meetings, had 6 firms indicate an interest to explore an investment and possibly submit a term sheet and 3 companies actually say they were ready to write a check. The other 3 are still pending but since I am close to agreeing a term sheet it doesn’t make sense to pursue things at this stage.

Biggest lessons …

1. people universally said to focus on the SMB market (SME in UK parlance) and MAYBE divisions of corporations. But not one VC thought I should go after big, enterprise clients. I had planned a balance of large companies and SMB/divisional sales but have changed my thinking. Reasons: cost of sales executives, long sales cycles, deep functional requirements.

2. the smartest guys I met in the process said I really needed to focus on customer adoption / usability. Most people agreed that if you had a document management need and were willing to load your documents into our system it was one of the most usable products they had seen. But how do you convince millions of people that need to be educated that they have a document management problems to upload their documents in the first place? We have invested heavily in this. People said, “invest more.” Making user adoption incredibly simple and shortening the time to a light going off in the user’s head that they see the value is critical in driving viral adoption. Think LinkedIn.

3. People were mixed on how much money we should raise. I only want to raise $2.5 million and some people believed ardently that we needed to raise $5 million. I guess it was unsurprising that the people who were sure we needed to raise more money tended to have very large funds. We want to build the company slowly and pragmatically serving the needs of our existing customers.

4. I met a lot of really bright people that were passionate about and experienced in helping entrepreneurs build successful businesses. I think good VC’s really do make a difference. I look for firms in which some of the partners (my partner) have operational experience and know what it’s like to wake up every day and be an entrepreneur. I have raised capital in the past from European firms and from US firms. There is really no other place in the world like Silicon Valley. The amount of experience that exists in these 40 or so miles is phenomenal. I was a bit humbled by some of the companies that were funded by the people that I had met.

5. My partners Tim Barker and Ryan Lissack are both absolute superstars. Tim handled the product management, vision, roadmap and competitive questions like a pro. Ryan was my savior when it came time for questions on how SOLR clustering works, why Postgres was more suitable to us than MySQL and why aspect-oriented programming was delivering us benefits in the development process.

I look forward to the next phase of our business. We will hopefully close on a $2-3 million financing round at some point in January and I can get back to the full time work of running my business. I can get back to sleeping by midnight and posting blogs more frequently. The venture capital process is a necessary and informative experience that is not for the faint hearted. It helps one refine your business focus and share ideas with some of the brightest minds in the industry and be challenged by people who have seen every eventuality in the type of business you want to build. But … I sure will be glad to get back to being a full-time CEO.

END OF ORIGINAL POST

Prologue:

The managing partner of the venture firm called me the day after they were exposed on the front page of Valleywag.  I was nervous and mortified.  He was a gentleman.  He apologized and said that their firm had learned from the incident.  He vowed to make sure that his colleagues never behaved like that in a startup meeting again.  He handled this perfectly.  Here’s the link to the Valleywag teaser article (they have since purged the full article).